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Penalty clauses: what is the test where a clause is claimed to be unenforceable?

The Supreme Court has recently considered two appeals relating to whether certain contractual clauses were penalty clauses (and therefore unenforceable) and restated the principles underlying the penalty rule.

This area of law had not been reviewed in the Supreme Court for over a century, with DunlopPneumatic Tyre Co Ltd v New Garage & Motor Co Ltd the leading case.

Facts

Though heard jointly, the two cases differ substantially in fact. In Cavendish, the Defendant sold a controlling stake in a company to Cavendish, agreeing the purchase price was payable in instalments. The agreement also included an anti-competition covenant. Should the defendant compete, the agreement contained two clauses – one stating he forfeited his right to the final two purchase price payments, and the other stating he could be forced to sell his remaining shares at a price based on asset value, ie at a price which excluded goodwill. Mr Makdessi breached the covenant and Cavendish brought proceedings. Mr Makdessi argued the clauses were penalties and therefore unenforceable.

ParkingEye revolved around an £85 parking charge Mr Beavis was given for overstaying a two hour parking limit at a shopping centre. Mr Beavis contested his liability on the basis it was either a penalty or contrary to the Unfair Terms in Consumer Contract Regulations 1999.

The old test

The decision in Dunlop contained a set of principles to assist in determining if a clause could be considered a penalty. The over reliance and quasi statutory status of these principles was heavily criticised in the Supreme Court’s judgment.

The original test in Dunlop considered whether a clause was a genuine pre-estimate of a party’s loss or had a deterrent effect. If it was a genuine pre-estimate it was enforceable, but if it bore no relation to the maximum loss a party could have realistically suffered, and its purpose was to act was a deterrent, it was a penalty.

It is important to note the Supreme Court has not abolished Dunlop, it is still applicable when deciding if a clause is a penalty, but it has also created a new test.

The new test

Whether a clause is a genuine pre-estimate of loss or acts as a deterrent is not a deciding factor in the new test. Instead, it contains two steps:

Is a legitimate business interest being served and protected by the clause?

Is the provision made for that interest extravagant, exorbitant or unconscionable?

The Supreme Court also confirmed that the interest does not necessarily have to be financial, it can also apply to obligations to transfer assets (as was the case in the second clause of Cavendish). In addition, a clause does not have to purely cover compensation for breach, it can take into account wider interests.

Outcome

The Court held that in both Cavendish and ParkingEye the clauses were not penalties and were enforceable.

On the facts of Cavendish, both clauses had a legitimate interest to protect the goodwill of the Cavendish group, and the clauses were not extravagant in the context of a carefully negotiated agreement between two legally advised parties.

In ParkingEye, the Court recognised that under the Dunlop principles the charge would not have been considered a genuine pre-estimate of loss, and could be considered to have a deterrent effect. However, the Court determined that ParkingEye had a wider legitimate interest – namely the interests of its employers/landowners. It also did not consider the scheme excessive or unconscionable simply because some customers underestimated the time required for shopping. Both limbs of the new test were satisfied.

Points to note

It is important to note that the relevant provisions in Cavendish were contained as terms of the sale of a business, in an extensively negotiated document between parties of equal bargaining power. In employment contracts there is assumed to be an inequality of bargaining power. The clauses found within employment contracts are, therefore, more likely to be assessed with far greater scrutiny.

The new test provides far greater flexibility than principles in Dunlop, but this also results in more uncertainty as to what is or is not a penalty clause. There is particular concern over how certain terms in the new test will be interpreted and defined, namely “a legitimate interest” and “extravagant, exorbitant or unconscionable”.

It is important to remember that Dunlop has not been abolished. The principles do still apply, and in straightforward damages cases it is possible the Dunlop principles alone will be adequate in determining the validity of the clause.

For employers, when seeking to avoid falling foul of the penalty doctrine, when for example drafting a restrictive covenant in an employment contract, the following should be borne in mind: ensure that the drafting provides for a series of primary and/or conditional primary obligations which fall outside the scope of the penalty doctrine all together. It may also be wise to specifically address the commercial rationale and legitimate business interests being protected and the proportionality between the detriment in question and potential consequences of breach.

The new rule applies to all future cases, so will have a retrospective effect, as the new rules will apply to disputes relating to contracts already in existence.

Compare jurisdictions: Arbitration

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